Retirement Withdrawals: What Rate Is Safe When Time Is Short and Uncertain?

by Carl M. Hubbard

!

How much can I withdraw? is the key question facing investors who are living off of their retirement savings. The dilemma is that if they withdraw too much, they prematurely exhaust the portfolio, but if they withdraw too little, they unnecessarily lower their standard of living.

Many financial studies have examined sustainable withdrawal rates to help answer this question. But most of this research covers payout periods that are typically 15 years to 35 years. The imagined scenario typically focuses on a 65-year old retiree who is planning withdrawals that allow the retirement portfolio to provide income for 15 years to 35 years.

However, circumstances of life arise that can shorten the expected payout period.

One example hit close to home when a friend revealed that he had just been diagnosed with a life-threatening disease. Standing plans for a long, enjoyable retirement suddenly evaporated. In their place were guarded expectations of a few years of active life interrupted by periods of struggle for survival.

If I carve out a portion of my retirement fund to finance travel and activities that I have postponed until retirement, how much can I consume over a few years? was his question.

A similar circumstance faces any individual at an advanced age who recognizes that only a few years of life remain. In each of these circumstances, individuals may wish to accelerate withdrawals from all or perhaps a portion of their retirement portfolio.

A laddered portfolio of zero-coupon bonds is a common investment plan for a known and rather short payout period with known withdrawalsfor example, a four-year plan for college education expenses.

In the circumstances described above, however, the payout period is uncertain, and exact withdrawal amounts are not required. The individual planning for a five-year payout might actually experience a longer or a shorter period of time. With these uncertainties, a portfolio of cash, cash equivalents, or laddered zero-coupon bonds could easily be consumed too early. In addition, there is very little upside potential in a short-lasting laddered portfolio of zero-coupon bonds and none for cash.

In contrast, investment in common stocks provides the opportunity for higher returns than do bonds and cash, and higher returns allow for higher sustainable withdrawal rates. In addition, the higher returns to common stocks may provide a significant terminal value for the portfolio, which bonds and cash cannot offer without significantly reducing withdrawals.

To help retired investors who are faced with these kinds of circumstances, we examined the sustainability of a range of comparatively high withdrawal rates from portfolios of stocks, bonds, and U. S. Treasury bills over five-year payout periods.

TABLE 1. Stock/Bond Portfolio
Success Rates With Monthly Withdrawals Over Five Years: 19462003 (percent of all past payout periods supported by the portfolio)

Portfolio Allocation

Withdrawal Rate as a % of Initial Portfolio
Value

17%

18%

19%

20%

21%

22%

23%

24%

25%

26%

27%

Fixed Monthly Withdrawals

100% Stocks

100

98

98

96

91

85

78

72

65

54

50

75% Stocks/25% Bonds

100

100

98

98

91

83

76

69

56

50

39

50% Stocks/50% Bonds

100

100

100

98

96

81

74

59

46

30

24

25% Stocks/75% Bonds

100

100

100

100

89

72

57

39

28

20

17

0% Stocks/100% Bonds

100

100

100

87

67

57

37

28

24

17

7

Inflation-Adjusted Monthly Withdrawals

100% Stocks

98

94

89

83

80

78

65

52

48

46

39

75% Stocks/25% Bonds

98

96

91

83

80

70

61

48

46

35

24

50% Stocks/50% Bonds

98

96

91

81

72

65

56

41

26

19

11

25% Stocks/75% Bonds

100

100

100

87

67

57

37

28

24

17

7

0% Stocks/100% Bonds

94

91

81

65

48

35

26

17

9

6

6

Sources: Authors calculations based
on data from Ibbotson Associates and from the U.S. Department of Labor, Bureau
of Labor Statistics.

Our Approach to the Problem

We examined the sustainability of withdrawal rates over five-year payout periods using rolling historical time period returns advancing annually from January 1946 through December 2003, for a total of 54 five-year payout periods. The Standard & Poors 500 index represents stocks and long-term, high-grade corporate bonds represent the bonds. Each portfolio starts with an initial $1,000, and monthly withdrawals are made at the assumed withdrawal rate as a percentage of the portfolios initial value. We examined both fixed monthly withdrawals and inflation-adjusted withdrawals in which the initial withdrawal is increased by the inflation rate in subsequent months. Throughout each 60-month period, a portfolio is assumed to retain the desired stocks/bonds asset allocation percentages by monthly rebalancing. A withdrawal rate is considered sustainable if the initial $1,000 portfolio completes the 60-month payout period with a positive value. Any portfolio that is depleted prior to the conclusion of the 60-month process of accruing returns and making withdrawals is a failure. A higher portfolio success rate suggests greater sustainability of the related withdrawal rate over a five-year payout period.

Portfolio Success Rates and Terminal Values

Table 1 presents portfolio success rates for a range of annual withdrawal rates (17% to 27%) from various portfolio allocations of stocks and bonds and for fixed monthly withdrawals and inflation-adjusted withdrawals.

For example, consider the 17% withdrawal rate for the all-stock portfolio. Historically, the all-stock portfolio supported 100% of the 54 five-year periods when 17% of the initial portfolio value was withdrawn each year in fixed monthly installments. If we increase the monthly withdrawals to reflect inflation in the preceding year, then the portfolio success rate drops to 98% (one failure in the five-year period ending 1977).

As shown in Table 1, higher annual withdrawal rates and periodic inflation adjustments to withdrawals reduce portfolio success rates. Also, increasing the percentage of bonds in portfolios tends to lower portfolio success rates. Because of the relatively short payout period (five years), annual inflation adjustments are less important than for longer periods of 25 years or 30 years. Still, individuals who prefer larger payouts in later years and smaller payouts in earlier years may choose inflation-adjusted withdrawals.

TABLE 2. Terminal Value of a
$1,000 Initial Portfolio After Monthly Withdrawals for Five Years: 19462003

Portfolio Allocation

Fixed Monthly Withdrawals

Inflation-Adjusted Withdrawals

Withdrawal Rate as a % of Initial Portfolio Value ($)

19%

20%

21%

22%

23%

19%

20%

21%

22%

23%

100% Stocks

Average ($)

569

501

435

373

315

476

410

348

288

234

Midpoint ($)

568

498

430

364

297

436

348

259

172

97

Minimum ($)





















Maximum ($)

1,707

1,612

1,518

1,423

1,328

1,632

1,534

1,435

1,336

1,237

75% Stocks/25% Bonds

Average ($)

476

411

346

287

231

383

320

261

206

160

Midpoint ($)

459

389

321

252

190

346

265

191

118

52

Minimum ($)





















Maximum ($)

1,281

1,198

1,115

1,032

949

1,213

1,126

1,039

952

865

50% Stocks/50% Bonds

Average ($)

394

330

267

210

159

301

242

189

142

100

Midpoint ($)

365

305

246

187

124

276

212

151

82

18

Minimum ($)

43



















Maximum ($)

1,042

958

874

790

706

915

825

734

643

567

25% Stocks/75% Bonds

Average ($)

320

258

199

146

104

233

178

131

91

59

Midpoint ($)

254

192

134

75

15

196

138

79

19



Minimum ($)

57

3

















Maximum ($)

1,101

1,016

932

848

763

973

882

791

699

608

100% Bonds

Average ($)

253

196

147

107

77

176

129

93

64

42

Midpoint ($)

195

135

73

13



101

47







Minimum ($)

26



















Maximum ($)

1,152

1,067

982

898

813

1,023

931

840

748

657

Sources: Authors calculations based
on data from Ibbotson Associates and from the U.S. Department of Labor, Bureau
of Labor Statistics.

Why Not Simply Hold Cash?

Taken together, the results of Table 1 might seem to indicate that investors should not invest in either common stocks or long-term bonds when facing a short-term payout period such as five years. Quite literally, an investor could stuff his or her money in a mattress and withdraw 20% a year for five years with a 100% success rate. The table indicates that for an investor to withdraw the same 20% per year from a portfolio consisting equally of equities and long-term bonds, the probability of portfolio success is 98%. In other words, Table 1 seems to indicate that investing in equities and bonds is worse than putting your money in a mattress!

The one issue this ignores, however, is the value of the portfolio at the conclusion of the payout period. Taking out 20% per year for five years from under a mattress guarantees a portfolio terminal value of $0. A portfolio that includes stocksfor example, the 50% stocks/50% bonds portfolio in Table 1offers the opportunity for a higher withdrawal rate and a significant terminal value, neither of which is offered by the stuffing cash in the mattress strategy.

Table 2 presents portfolio values at the end of the five-year payout periods. You can see from the table that, despite the monthly withdrawals for five years, in many cases the portfolios still retain significant value.

Consider the case of fixed monthly withdrawals and a 20% annual withdrawal rate from the 50% stocks/50% bonds portfolio. Based on a $1,000 initial portfolio, the average and midpoint terminal values are $330 and $305. The highest terminal value ($958) occurred for the five-year period ending in 1986. There was only one failure among the five-year payout periods, and that occurred in November 1977, two months shy of success. One failure out of 54 five-year periods causes the portfolio success rate to be less than 100%i.e., 98%. Only when the portfolio success rate in Table 1 equals 100% will the minimum terminal value in Table 2 be a positive number. And only a person who is so risk averse that no portfolio failures are tolerated would choose cash in a mattress over a portfolio that contained some reasonable allocation to common stocks.

Over-reliance on long-term bonds in this unique circumstance likewise is not the best strategy. As the percentage of bonds in the portfolio increases, the average and midpoint terminal values decrease because of the limited upside potential of bonds. The maximum terminal value, however, is not as well-behaved as the average and midpoint. The maximum decreases when the bond allocation percentage increases but only to a point, then the maximum increases. The increases in the maximum are an artifact of the unusual and dramatic increases in bond prices caused by precipitous declines in interest rates during the mid-1980s. For both the fixed monthly withdrawals and inflation-adjusted withdrawals, maximum terminal values should be viewed as the outliers that they arerare and unusual.

Adding Treasury Bills to the Mix

Table 3 provides information similar to that presented in Table 1, the only difference being an additional security and different portfolio allocations. For short-term payout periods such as five years, individuals may wish to include cash equivalents in their portfolio. Table 3 presents portfolio success rates for portfolios consisting of stocks, bonds, and 30-day U.S. Treasury bills.

Sources: Authors calculations based
on data from Ibbotson Associates and from the U.S. Department of Labor, Bureau
of Labor Statistics.

In general, the addition of Treasury bills in the portfolio produces larger changes in success rates for higher withdrawals than for lower withdrawals. Because Treasury bills reduce the variation of portfolio returns, portfolio success rates for stock-heavy portfolios in the 21% to 24% range are enhanced by the presence of Treasury bills in the portfolios. A comparison of the portfolio success rates net of inflation-adjusted withdrawals in Tables 1 and 3 shows no advantage to holding short-term Treasury bills or cash equivalents. Because inflation consumes the returns to Treasury bills, inflation-adjusted withdrawals are better supported by stocks and bonds.

Table 4 provides terminal values for a range of withdrawal rates, both for fixed monthly withdrawals and inflation-adjusted withdrawals. The average and midpoint terminal values of portfolios reported in Table 4 are lower than those in Table 2. The maximums in table 4 also are lower than those in Table 2. Thus, including as much as 20% cash in a portfolio reduces the opportunity for higher terminal values at the conclusion of the payout period.

Maximum Sustainable Annual Withdrawal Rate

What maximum annual withdrawal rate as a percentage of initial portfolio value can be sustained over a five-year period?

The answer depends on portfolio allocation, whether or not withdrawals are adjusted for inflation, and the portfolio success rate that is required.

To illustrate, consider a portfolio comprised of 50% stocks and 50% bonds. Assume that monthly withdrawals are not adjusted for inflation, and that a portfolio success rate of approximately 75% is required for a withdrawal rate to be deemed sustainable. Table 1 shows in this case that a 23% annual rate is sustainable since historically such portfolios have successfully supported that rate 74% of the time.

This strategy worked roughly three out of four times in the past, but it failed one out of four times. Because of potential failure, the withdrawal rate may have to be reduced for the portfolio to last for five years. Such mid-course corrections are not unusual and should be expected, even though for planning purposes, 23% may be a reasonable withdrawal rate.

In many cases in the past, the 23% annual withdrawal rate could have been increased because of good fortune in the capital markets. The 74% success rate means that 40 of 54 past five-year periods were supported by the 50% stock/50% bonds portfolio even though 23% of the initial portfolio value was withdrawn each year. Moreover, the value of the portfolio at the end of the five-year period in these 40 cases ranged from $4 to $706 per $1,000 initially invested. As shown in Table 2, despite the annual withdrawal over five years of $230 per $1,000 initially invested, many of these portfolios retained substantial value, over half in excess of $100 per $1,000 initially invested.

TABLE 4. Terminal Value of a
$1,000 Initial Portfolio That Includes Treasury Bills After Monthly Withdrawals
for Five Years: 19462003

Portfolio Allocation

Fixed Monthly Withdrawals

Inflation-Adjusted Withdrawals

Withdrawal Rate as a % of Initial Portfolio
Value

19%

20%

21%

22%

23%

19%

20%

21%

22%

23%

80% Stocks/20% Treasury Bills

Average ($)

479

415

353

293

236

387

323

264

207

157

Midpoint ($)

498

429

361

292

224

380

293

206

125

48

Minimum ($)

12



















Maximum ($)

1,255

1,172

1,089

1,006

923

1,201

1,112

1,023

934

844

60% Stocks/20% Bonds/20% Treasury Bills

Average ($)

411

348

286

227

173

320

258

201

149

106

Midpoint ($)

403

335

268

204

139

310

229

149

81

19

Minimum ($)





















Maximum ($)

990

913

836

759

682

924

844

763

683

602

40% Stocks/40% Bonds/20% Treasury Bills

Average ($)

349

288

227

170

120

259

200

147

102

64

Midpoint ($)

320

258

196

137

77

240

179

114

52



Minimum ($)





















Maximum ($)

877

798

719

640

561

755

670

585

500

414

20% Stocks/60% Bonds/20% Treasury Bills

Average ($)

292

232

174

121

81

206

151

103

66

39

Midpoint ($)

224

167

110

54



176

118

59

1



Minimum ($)





















Maximum ($)

918

839

760

681

602

795

710

624

539

453

0% Stocks/80% Bonds/20% Treasury Bills

Average ($)

239

182

131

92

62

161

112

76

48

30

Midpoint ($)

198

138

77

18



96

42







Minimum ($)





















Maximum ($)

954

875

796

717

638

831

745

660

574

488

Sources: Authors calculations based on data
from Ibbotson Associates and from the U.S. Department of Labor, Bureau of Labor
Statistics.

Fourteen of the 54 past five-year periods, or 26%, ended in failure. In each of these cases the portfolio became depleted prior to the end of the five-year period because of the annual withdrawals. But when did failure take place? Failure just before the end of the five-year period would seem less serious than failure well before the end. In fact, 12 of the 14 failures occurred in the six months prior to the end of the five-year period, meaning that they missed being counted as successes by only a few months. The most severe failure occurred in month 50 and the second most severe, month 54. In such cases small mid-course reductions in withdrawals would have allowed the portfolios to succeed.

Using similar analysis suggests maximum sustainable annual withdrawal rates for other scenarios, including:

21% for the 50% stock/50% bond portfolio with inflation-adjusted withdrawals;

Conclusion

The maximum sustainable annual withdrawal rate from a portfolio over a five-year period depends on the mix of securitiesstocks, bonds, and billsin the portfolio. What rate is judged as sustainable also depends on an individuals degree of risk aversion with respect to falling short of the five years.

Despite the subjectivism necessarily introduced by the degree of risk aversion, we offer the following conclusions:

Based on historical returns in the capital markets, the maximum sustainable annual withdrawal rate as a percentage of initial portfolio value is in the range of 21% to 23% for stock-dominated portfolios.

In contrast to long-term payout periods, for short-term payout periods such as five years, individuals are less likely to demand inflation adjustments to the monthly dollar withdrawals. If such adjustments are required, however, then the annual withdrawal rate needs to be lowered by one or two percentage points.

The addition of bonds and Treasury bills to the portfolio increases the success rates at low withdrawal rates. The addition of stocks to the portfoliobecause of their upside potentialincreases success rates at high withdrawal rates.

While it might seem that these results are not much superior to stuffing the money in a mattress, in fact, investing in long-term assets even for this relatively short-term period produces real benefits. By investing in stocks (50%) and bonds (50%) and withdrawing 20% per year for five years, the individual will have almost the same 100% portfolio success rate as the mattress investor, but will have an expected portfolio terminal value of $330 per $1,000 invested instead of zero with the mattress strategy. For stock-dominated portfolios and annual withdrawal rates up to 23%, terminal value is likely to be substantial at the end of five years. That terminal value can be used to maintain constant expenditures beyond year five, or to step up spending in the latter years, or it can be given to heirs.

Philip L. Cooley, Carl M. Hubbard and Daniel T. Walz are professors of business administration at Trinity University in San Antonio, Texas

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